RachelKoning Beals

Fixed-income investors are — and have been — readying for rising interest rates and uncertain inflation risks. It’s a to-be-expected part of the economic cycle that’s been unexpectedly complicated by Japan’s earthquake, Middle East and North Africa political uprising, the rising debt burden of Europe and the United States, plus the global recovery’s herky-jerky performance.

Middle East upheaval and questions about U.S. economic strength cloud the outlook for stocks,
says Bernard Baumohl, chief global economist at The Economic Outlook
Group.

Planning ahead is advisable in both life and investing. But getting the timing and scope of sometimes costly protection just right, that’s the tough part. Prospects for higher future rates diminish the worth of bonds already in circulation, while the inflation that can accompany stronger economic growth eats up the fixed payments earned on bond investments.

“With interest rates at historic lows and Uncle Sam’s debts at historic highs, millions of investors fear that a sustained march to higher bond-market yields is inevitable and all but imminent, and that the damage is going to be persistent and devastating,” said Eric Jacobson, director of fixed-income research at investment researcher Morningstar Inc.

“That worry is as intense as ever, despite considerable reason to think that the effect will be less catastrophic than many fear,” he added. “After shoving hundreds of billions of dollars into bond funds, which had been rallying on the back of falling Treasury yields and a credit-and-liquidity driven rally for most of 2009 and 2010, the wave has tapered, and investors have been desperate for an interest-rate refuge.”

For now, bond funds logged a modest early-year gain as global uncertainty kept up some demand for the perceived relative safety of bonds. But that performance eluded longer-term government debt funds, which lost value when expectations for higher future rates softened current prices. Certain municipal bond funds also dipped into the red in step with rising Treasury yields and what was, according to some market participants, an unnecessary rush to the exits once selling began.

High-yield corporate bond funds were up 3.6% in the quarter, leading all fixed-income categories, according to preliminary Morningstar data. Their performance tracked signs of economic improvement and the upward trend for stocks. Although the major equity-market averages slid backward on worries of global nuclear implications from Japan’s quake and tsunami, they eventually returned to a retest of pre-2008 financial crisis levels.

In the other column, long-dated government bond funds fell 1.6% in the period, the only negative performance in the taxable space. Their inflation-protected counterparts, by contrast, added 2% in the quarter. Short-term government bond funds ended the period essentially flat, Morningstar reports.

The bond king’s speech

U.S. government securities have lost 0.3% so far this year through the end of March, according to Bank of America Merrill Lynch indexes. In that same timeframe, the Standard & Poor’s 500-stock index gained more than 5%.

Bill Gross, the closely followed head of bond investing giant PIMCO, has been proclaiming his dislike for Treasury investments over several months now. In his latest web-posted commentary, Gross said Pimco “has been selling Treasurys because they have little value within the context of a $75 trillion total debt burden.”

Government bond action in the first quarter justified Gross’s early call.

Treasury prices fell and yields rose once again late in the quarter as financial markets got their first clue in some time on the thinking of certain Federal Reserve members.

St. Louis Fed President James Bullard said at a conference and separately in a television interview that while the central bank would still have to determine the timing for stopping its bond-buying boost for the economy, and eventually wean the economy off ultra-low interest rates, the Fed may not automatically delay such moves because of spikes in oil prices and other economic hiccups linked to Japan’s quake, geopolitical fighting and a spotty global recovery.

“If the economy is as strong as I think and hope it will be in 2011, I think it will be time for us to start to reverse our ultra-aggressive and ultra-easy monetary policy,” Bullard told reporters at a financial conference in Prague in late March, according to news reports. “We could pull up a little bit shy of our [Quantitative Easing] total.”

The Fed may need to trim about $100 billion from its plan to buy $600 billion in Treasury securities because the U.S. recovery has gained strength, according to Bullard. He is not a policy voter this year but does participate in policy discussions.

Bullard’s comments and general market sentiment put upward pressure on rates and downward pressure on bond prices in part on expectations the Fed may no longer be the steady Treasury customer that it’s been for some time now. Add to that: Japan’s need to rebuild from the quake could start to pull its investment out of U.S. government debt and back into its own markets.

Futures traders have increased their bets that Fed policy makers will raise borrowing costs at their January 2012 meeting. Fed funds futures levels in late March showed a 51% chance of an increase in the target rate for overnight lending between banks, compared with 44% odds priced in around mid-month. The Fed has kept its benchmark at zero to 0.25% since December 2008.

For certain, it’s been a tough call for Fed members and fund managers alike. Housing is still a drag on the economy but other signs of consumer and business spending have been improving. The economy’s significant laggard tends to be the job market: Nonfarm payrolls grew in March at their fastest pace since May 2010, the Labor Department said Friday, suggesting an improving labor market. Read more: U.S. employment picture improves.

Rattled by reports

There are risks to the upbeat economic scenario. “Widening credit spreads and the continued fiscal stress in Greece and Ireland are bringing [Europe’s debt] back to the headlines. We expect the issue to again come to a head later this year,” said economists at Wells Fargo Advisors, in a research note. “Rising food prices also increase the risks to the outlook. With consumers spending more on food and gasoline, they have less to spend on everything else. This is an even larger problem for developing countries, where food and energy expenditures account for a larger proportion of discretionary income.”

Municipal bond funds have been the most volatile of the bond categories of late. Long-term national muni bond funds ended the period flat, according to Morningstar data. Intermediate national muni bond funds rose 0.5% and their short-term counterparts rose 0.4%. Long-dated California bond funds fell 0.9%, while funds that hold New York- and New Jersey-issued debt were down 0.4% and 0.5%, respectively. High-yield muni funds slumped 0.9% in the quarter, leading the decliners.

Rob Williams, director of income planning at the Schwab Center for Financial Research, said the exodus out of muni bonds and related funds late in 2010 and so far this year has been overblown and may present a value opportunity for longer-horizon investors willing to hunt for quality within the $3 trillion market and its more than 10,000 active debt issuers.

Rising Treasury yields on the horizon cuts into the relative value of current munis, which pay out lower rates than other bonds due to their tax benefit. As Treasury yields start to creep higher and bond prices fall, muni investors tend to “sell first and ask questions later,” Williams said.

“One upside to all of the [media] attention is that it’s helped force many state and local governments to acknowledge and then try to tackle budget challenges, including public-employee pensions and rising entitlement costs,” he said. “This is a positive development and a continued support, we believe, for the credit quality of most muni issuers for the long term.”

Default risk has been excessive even among high-profile debt-strapped issuers like California, Illinois and New Jersey, he noted, stressing that investors must remember debt generated from these three do pay out higher yields for a reason. Williams said he sees better value currently among munis compared to Treasurys and some corporates.

What is clear is that across the fixed-income space, interest-rate risk should now be the bigger concern among investors than credit risk, he said.

Added Williams: “The national economy is improving, moving from recovery to expansion and that’s likely to put some upward pressure on rates. It will start with Treasurys and spill over to munis.”

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